UK Pension Scheme Types
Updated: May 18, 2022
This article will give you a basic overview of the main types of pension scheme currently in operation within the UK. At present there are generally three main types of UK pension scheme.
An individual may be eligible for one or more state pensions. The amount of state pension accrued by an individual over their working lifetime depends on their National Insurance contribution or NIC record.
The eligibility for state pensions has changed for those individuals who reach state pension age (SPA) on or after the 6th of April 2016. Individuals who reached their SPA before the 6th of April 2016 receive state pension benefits based on the rules that existed prior to the 6th of April 2016.
On the 6th of April 2016, the new state pension came into force, this has also been called the single tier state pension. Those reaching their SPA on or after the 6th of April 2016 are not entitled to the state pension in the original format but will instead receive the new state pension. However, existing benefits accrued under the earnings-related parts of the state pension will be accounted for in calculating an individual’s entitlement, to ensure that no one is worse off under the new system.
In addition, any periods when the individual was contracted out under the pre 2016 rules will be taken into account.
Defined benefit or final salary pension schemes
A defined benefit scheme provides benefits that are guaranteed to be a proportion of final salary at retirement, or on death, hence their other name of final salary schemes.
They may be provided by both the private sector i.e. schemes provided by private employers, and the public sector for example the NHS pension scheme or the teachers’ pension scheme.
Defined benefit schemes tend to provide superior benefits to other types of pension scheme, in terms of both the level and range of benefits. The major advantage of this type of scheme for the employee is the guaranteed nature of the benefits.
The scheme sets a normal retirement age, which is usually the age up to which employer contributions will be paid, and this will be the age at which members will usually retire.
The benefits that a defined benefit scheme will provide will be based on the following three factors.
Pensionable service. This is usually the employees period of membership in the scheme,
Pensionable remuneration, this is the definition of salary that is used to calculate the members benefits,
and the accrual rate, the rules of the scheme will determine the rate at which benefit accrues for example 1/60th or 1/80th of pensionable remuneration for each full year of pensionable service.
As well as a pension a defined benefit scheme will also provide a tax-free cash lump sum, known as the pension commencement lump sum or PCLS at retirement. The rules of the scheme will determine how much tax-free cash can be accrued for each year of service.
Money purchase or defined contribution pension schemes
Unlike a defined benefit scheme, a money purchase scheme does not provide the member with guaranteed benefits. Instead, a fund builds up and the benefits that are ultimately provided depend on the size of the fund at that time.
If the member chooses to purchase a lifetime annuity, the actual level of income will depend on the annuity rates when benefits are taken.
Generally, part of the fund may be taken as a PCLS and the amount of the PCLS is usually limited to 25% of the value of the fund. The value of the fund also determines the amount of death benefits paid to the members chosen beneficiaries on the members death. These schemes are often collectively called defined contribution schemes.
A money purchase scheme may be an occupational scheme provided by an employer for the benefit of the employees, or it may be an individual arrangement funded by the member themselves.
You may have come across various types of pension arrangement e.g. personal pensions, stakeholder pensions, executive pensions, self-invested personal pensions (SIPSs). These are all money purchase schemes.
Some money purchase schemes are hybrid schemes, e.g. targeted money purchase schemes. This type of scheme is funded to provide a specific amount of benefit at retirement, typically a proportion of salary size.
Since the 6th of April 2015 an individual is able to take as much or as little as they like from their money purchase arrangements once they reach the normal minimum pension age currently 55, but rising to 57 in the next decade.